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Hurricane Sandy showed no mercy when it slammed into the Northeast of the United States late last month. With its ferocious winds and powerful ocean surge, the monstrous category 1 storm (which was later downgraded to a strong tropical system) packed a heavy punch, leaving behind widespread devastation and damage to homes and businesses, and, in some cases, loss of human life. The insurance industry is, no doubt, feeling the effects, too. Here, we focus on Dow 30 component The Travelers Companies (TRV - Free Travelers Stock Report) to give investors an idea of how a property/casualty insurer might be affected by such a catastrophic event as a hurricane or similar natural disaster. This should help investors know what to look for when evaluating an insurance equity.

For starters, folks should be aware that major differences in the reporting format exist between a P/C insurance outfit and a standard industrial company. In the following discussion, we highlight some of the terms that are unique to insurers. Premiums Earned, found in the Statistical Array in the middle of the Value Line page and in the quarterly box on the lower left-hand side, is one such item that is common to insurers. It refers to the amount of money (or “premiums”) an insurer receives from policyholders to compensate it for the risk it assumes. Premiums function similarly to “Sales” or “Revenues” for a typical industrial firm. New business wins, rate increases, and adjustments to terms and conditions often influence the number.

Just below the Premiums Earned line in the Array we find three of what are among the most significant figures for an insurer, all of them expressed as aUsing the VL Page_Historical Array percentage. The Loss to Premiums Earned (or “loss ratio”) represents the losses incurred by the insurer, or the portion of earned premiums that is paid out to customers when claims are filed. Major catastrophes can inflate this figure, although an insurer’s degree of exposure to risk plays a role, too. The lower the percentage, the more favorably it is viewed.

The Expense to Premiums Written (or “expense ratio”) reflects the operating costs, including actuarial expenses and employee salaries, associated with the writing of policies. Note that Premiums Written does not appear on our page, but refers to the amount of business an insurance company brings in. Although a rising expense ratio would seem to suggest business growth, an increase could mean the insurer is not retaining or renewing accounts, which would be a negative.

The sum of the two ratios mentioned above, dubbed the “combined ratio”, is an especially important measure in the insurance business. While not explicitly shown, it is frequently referred to by insurers. Indeed, the combined ratio is used to derive what is known as the Underwriting Margin, a key metric that indicates how well an insurer is doing. It is essentially the difference between 100% and the sum of the loss and expense ratios. A positive number connotes an underwriting profit, while a negative figure indicates an underwriting loss. More specifically, it relates to the company’s insurance operations only, not total corporate activities.

In the case of Travelers, the combined ratio bears watching. Given the company’s sizable exposure to the Northeast, it is very likely that the impact of Hurricane Sandy will push the loss ratio up in the near term. Indeed, the company has a good chunk of the commercial property, auto, and homeowners insurance markets, so it will probably take a hit. We imagine it will be a bigger loss than it incurred last year with Hurricane Irene.

On the flip side, the company should have the opportunity to bounce back. While a catastrophe of this magnitude will likely take a toll on profits, Travelers, along with other industry peers affected by Sandy, will probably seek to raise rates and possibly trim exposure to some of its riskier business. That, in turn, should positively affect Premiums Earned, as well as the Underwriting Margin over time.

Meanwhile, another item worth looking at is Investment Income, located near the top of the Array as a per share number. A vital part of operations, investment income is essentially what an insurer receives on its investment holdings. Further down in the Array is Investment Income/Total Investments, which represents the rate of return from its total investments. Generally, an insurer invests in a variety of securities, with the purpose of generating sufficient returns to be able to pay out claims if and when they arise. For this reason, an insurer’s portfolio is typically composed of conservative, fixed-rate securities, like bonds, that offer a good yield. Equities can also be included in a portfolio.

 The Financial Position box on the left-side of the page provides a glimpse of an insurer’s portfolio makeup. For Travelers, we see that the amount of Fixed Maturities is overwhelmingly larger than that of Stocks. In the same section, we find Reserves. This acts as a cushion, or money set aside, in the event that aUsing the VL Page_Top Label catastrophe occurs and claims have to be paid out. All of these items come directly from the balance sheet.

Investors should also be familiar with an insurer’s Book Value (expressed as a per share number in the Array). This figure represents the total value of an insurer’s assets, including the investment portfolio. Often, an insurer’s stock price (located in the Top Label part of the page) is compared to the Book Value (known as Price to Book Value, also in the Array). While this should not be the only decisive factor in picking an insurance stock, it certainly helps give some guidance. A percentage of less than 100% means the stock is trading below its book value, and is thus considered to be undervalued. If the percentage is above 100%, the stock is overvalued. Looking at Travelers, the stock has been undervalued since 2009. But this may change, depending on how it fared with losses related to Sandy.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.